How Free-Market Fundamentalists are Hopelessly Wrong, II: the theory

In Part I we saw that readily available evidence shows clearly that economic performance in the free-market era that began around 1980 was already poor, even before the disaster of the Global Financial Crisis.  Here we look at the theory that underlies the free-market rhetoric, the so-called neoclassical theory.

This theory is an abstraction well over 100 years old, from a time when the idea of a clockwork universe still prevailed in science.  To maintain mathematical tractability, the theory makes simplifying assumptions about people and firms.  It assumes we are narrowly rational and that we can foretell the future.  It assumes we have access to all relevant information for free, and can assimilate its implications immediately.  It assumes we are brute materialists.  It assumes there are no social interactions.  It assumes there is a limit to economies of scale, based on constraints peasant farmers used to face.

With enough assumptions like this, you can deduce, using clever mathematics, that a market will balance all supplies with all demands and the economic system will come to an equilibrium.  This “general equilibrium” turns out to be the most efficient conceivable configuration of this abstract system, in the sense of producing the most goods from the least inputs of human effort.

This abstraction has proven extremely seductive to rich people, because it seems to say they should keep making money as fast as they can, and to the mathematically inclined, because they can play endless games with the theory.

However it is absurd to suggest that this abstract theory has any relevance to real economies.  If any one of those assumptions is violated you predict very different behaviour of the economy.  If the behaviour is very different then the central theoretical conclusion, that a free-market economy comes to an optimal equilibrium, is lost.  Lost with it is the basis for all the free-market rhetoric.

For example if information is incomplete or delayed then feedback is too weak to restore equilibrium.  If there are social interactions then there are phenomena like herd behaviour that destroy equilibrium.  If we all cannot foretell the future then feedbacks are erratic and so is the system’s behaviour.  If economies of scale apply up to very large firms, like Microsoft or McDonalds, then one or a few firms can grow exponentially at the expense of others, and yield oligopoly or monopoly, which is not optimal.  And of course if we are more than brute materialists then perhaps we want more out of life than ever more stuff, inequitably distributed.

Abstract theories may be entertaining, but if you want them to be the basis of a science you must compare them with observations of real economies.  Manifestly, human beings cannot foretell the future.  Our decisions are often governed by reactions tuned to the survival of hunter-gatherers but not always sensible (“rational”) in modern circumstances.  Herd behaviours can be observed in fashion and the financial markets, and are well-known to the marketing industry, which exploits them intensively.  Many industries are dominated globally by a handful of firms.  New technologies frequently displace older technologies, with a new group of firms bubbling up exponentially and taking over, upsetting equilibrium.  All of these well-known features of modern economies contradict the theory.

Most tellingly, a near-equilibrium system should only exhibit abrupt change when physical circumstances change abruptly, as in a natural disaster or a war.  However there have been many abrupt falls in markets without any external provocation, as was recounted in Part I.  Thus, for example, in 1987 stock markets fell thirty or forty percent in a day, though thirty percent of the world’s factories had not been bombed overnight.  These sudden falls were driven by the internal dynamics of the system, and are symptomatic of dysfunctional internal interactions.

In science, the purpose of a theory is to provide guidance on the behaviour of the observable world.  The neoclassical theory bears no useful resemblance, in its founding assumptions and in its central prediction of equilibrium, to observable modern economies.  To apply such a deficient theory is to practice pseudo-science:  it is an activity that maintains the trappings of science, but that fails the central test of science, that it is a useful guide to the behaviour of observable economies.

The neoclassical theory was a heroic attempt for its time in the late nineteenth century.  However to an experienced real scientist it is laughable that such a deficient theory has retained currency for over a century.

The clear conclusion from Parts I and II is that free-market economics has no basis in theory or in practice for its claim that free markets are the best way to organise an economy.  There is no assurance that free markets in the real world will deliver an optimal, or even desirable, result.  The retarded performance of the past three decades, culminating in a market crash, bears out the falsity of the free-market fundamentalists’ claims.

Nor, to be clear where this is not going, is socialism the inevitable alternative.  There are good reasons why socialism is also insufficient.  The relative success of the post-war era suggests, on the other hand, that carefully managed markets offer a better basis for an economy.  We can probably do even better than such a social-democratic approach, but that is another story.



13 thoughts on “How Free-Market Fundamentalists are Hopelessly Wrong, II: the theory

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  7. Lorena

    Having read this I thought it was very informative. I appreciate
    you finding the time and effort to put this informative article together.
    I once again find myself spending way too much time both reading and leaving comments.
    But so what, it was still worth it!


  8. graemebird

    Geoff one thing these Neoclassicals do is that they have assumptions to their models, and then they don’t learn or forget those models. So for example take banking. Their models assume that everytime a banker makes a loan the money is spent to buy machines that make workers more productive. That is the implicit assumption of their models. But we know that bankers borrow money to lend for land inflation, buying derivatives, takeover plays, consumer finance not excluding credit-card addiction, and this sort of thing.

    Worst of all you try and tell them where they are coming off the beam, they’ll think you are me and they’ll block you right away.


  9. graemebird

    Don’t let these Econ 101 crowd disuade you. I very much like reading your economics stuff. You bring fresh eyes to things. Not sure about your global warming gear. Seems you have chosen which tribe you are in on that one.

    To me the two rational schools of economic thought are the Austrian and the British Classical schools. When they move from their constructed models to diagnosing the real world they take on the same sorts of bad habits and error as the neoclassicals but not quite so egregiously. However this school is soft on oligarchy. If we don’t want to die or cry ourselves to sleep every night we cannot be soft on oligarchy.

    These people are soft on the effect of artificial persons, agency, and derivatives. In every case I think less soft then the horrible banker-imperialists (the neoclassicals) but still a bit feeble just the same.

    Professor Keen (who with his comrade (Professor Hudson)) is the most powerfully interesting centre-left economist right now)) …… Professor Keen has this sensational talk on emergent qualities.

    The coolest thing he says in this talk is:

    “Neoclassical economists don’t understand neoclassical economics.”

    When I saw him make this claim I was more or less pumping my fist, jumping up and down on chairs, and stroking my whiskers, because of the years of frustration I had had at Catallaxy and elsewhere dealing with working economists. Plus I like it that this older more educated man is dressing down hopeless pretenders like Greg Mankiw. Who seemed to have a cult following of very very lazy economists here in Australia. They saw Harvard, and they just went on auto-pilot.

    But here he gets, interesting all the way, to finally start talking on EMERGENT QUALITIES. Now I have a few caveats on what he says here. But this is the meat of his talk, and its very interesting.


  10. graemebird

    Let us now get to the crux of the problem. To state it like this in 1960 would have been ridiculous. To state it like this in 1973 would have been an exaggeration. To state it like this now still has some problems. But despite these problems let me make it as simple as possible.




    In 2013 this is all of us except the debt addicts. John Humphreys, me, BHP …. All perspons real and artificial are new money creation benefit MAXIMISERS. Profit is a derivative concern in 2013.

    You see the bankers, loathsome though they are, have to give up maybe two-thirds of their counterfeiting gains to their best customers. All but those who never go into debt, and those who are non-tax-deductible … debt-addicted, are into this game of trying to get as much of this counterfeiting benefit as they possibly can.

    This isn’t a subsidy coming from the welfare recipients to the rich. Its coming from the working poor. Its thieving from the working poor to give to the already rich. And it is not acceptable. Not now or ever.


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  12. skywanderer

    Excellent analysis with a well-established conclusion!

    “The relative success of the post-war era suggests, on the other hand, that carefully managed markets offer a better basis for an economy.”
    Exactly. The Western world needs to regain political freedom and democracy in order to have the freedom to move its economic system back to the grounds of benevolent regulation.



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